In finance, risk is classified as the expected return on an investment compared to the actual return. Risk management, therefore, is about reducing the financial risk and negative impact of unforeseen events. Managing risk is not only about protecting your future, but protecting what you currently have.
Right now, your family or business is probably operating on plan A: paying your monthly bills, spending within your means, and/or financing the various activities your kids throw your way. Depending on which stage you or your family is in, decisions about college funds, investment opportunities, and bigger purchases like real estate or vehicles might be on the table.
A cornerstone of wealth planning is to always be looking ahead. Plan A could be working, but each aspect of it carries certain risks. This is why risk management tools, such as insurance, exist: to protect you from significant financial detriment (i.e., buying a car involves purchasing accident insurance). However, certain events are unpredictable and unavoidable. And however unlikely they may be, the one time you’re not prepared could send you into financial ruin. Common, external risks that could affect your assets include:
- Stock market volatility
- Expensive medical procedures
- Vehicle accidents
- Unemployment
- Lawsuits
- Severe weather damage to your home
This is where plan B should be waiting on standby. Plan B contains a comprehensive inventory of “just-in-case” programs that address potential risk and are to be enacted in the event of catastrophic or damaging circumstances.
Constructing a risk management plan with your advisor is a step in securing your financial future. No two people are alike, so there are intricate details that will need to be discussed and tailored to your plan to ensure your individual objectives are met. However, there are some truths about risk management that transcend all walks of life.
Here is a brief overview of “must knows” to consider before and while planning for risk.
Do your research
Exploring various risk options is daunting for financial professionals, let alone novice planners. Nevertheless, the more preemptive research you do, the better. This will get you thinking about what is most important to you and send you in the right direction. Identify who is involved, what the structure is like, and the general guidelines to estimate the impact should those risks manifest.
Diversify
“Diversifying your portfolio” is a common, yet useful, proverb of wealth planning. To an extent, spreading your funds across different asset classes helps assure they’re not all exposed to the same risks. Their respective impacts become mutually exclusive: If one investment performs poorly over a certain time period, the other could just as easily be performing well during the same time. A diversified investment portfolio surpasses an unvaried portfolio in the long-term as markets fluctuate. Ask your advisor about different opportunities in order to make an educated decision.
Continually reassess your situation
In the financial industry, regulation changes are standard practice. This prompts us to examine how/if the changes affect our assets and investments. While you’re tinkering with the specifics of said new regulation, it’s a good time to reevaluate your status. Analyze both internal and external factors that are influencing your current environment to get a better idea of what you could be doing to continually improve. Don’t let a regulation change be the only trigger to do so. Even if things seem to be going swimmingly, taking the time to reassess your assets keeps you aware and prepares you for when accelerated change does happen. You might even stumble upon more opportunities you didn’t think of previously.
Monitor your leverage
Financial leverage can either be your best friend or your greatest disappointment. Low interest rates make the option of borrowing increasingly appealing, but it also elevates risk. The negatives may actually outweigh the positives. You may invest in what looks like strong stock, but a time of sudden market panic could result in liquidities drying up. This could corner you into an unfavorable position of selling your position below value and your initial investment.